The goal of refinancing a home loan is to lower your interest rate. A lower interest rate means a lower mortgage payment, allowing you to save on interest paid over the life of the loan.
It all sounds great, right? Well, don’t jump the gun. There are both benefits and drawbacks behind refinancing. With help from our friends at North Pacific Mortgage in Bothell, WA here is a list of pros and cons to consider before refinancing:
Lower Interest Rate
This is the main benefit. A lower interest rate reduces your mortgage payment and the interest paid in the future, saving you money to use for other purposes. This assumes your current loan and the new loan share the same term length/structure (i.e. 30-year fixed)
Upgrade From Adjustable (ARM) To Fixed Rate
If you currently have an adjustable-rate mortgage (ARM), you can switch to a more stable, fixed-rate mortgage. This would eliminate potential fluctuations in mortgage payments and protect you from paying greater interest should interest rates rise in the future.
Pay It Off Faster
Depending on your situation, you might find it advantageous to refinance into a shorter-term mortgage. For instance, if you can afford it, swapping a 30-year mortgage to a 15-year mortgage cuts down the life of the loan, saving you on interest and boosting your home equity in a quicker fashion.
Tap Into Your Cash Saved Up
If you possess enough equity in your home, another option is to replace your current mortgage with a larger one and withdraw the difference in cash. This is called a “cash-out refinance”. This allows you to use the resulting capital to pay off other debts, such as car or student loans that carry higher interest rates.
Bye-Bye Mortgage Insurance
If your initial down payment was less than 20%, you currently pay mortgage insurance. If you have owned the home for several years, your equity may have since grown to eclipse 20%, allowing you to ditch your mortgage insurance payments. This alone should make it appealing to refinance.
The cost of mortgage insurance can vary depending on a wide variety of factors that help address how much of a “risk” you are to the lender.
It Is Costly Up-Front
The cost to obtain a new loan is by far the biggest pitfall. There are typically two major expenses when refinancing (thanks to North Pacific Mortgage for help here):
Closing Costs: Direct costs to obtain the loan. This includes processing & underwriting fees, appraisal and escrow fees.
Pre-paids: Costs associated with owning the home. This includes homeowners insurance and taxes that are held in escrow.
The following example helps illustrate the costs to refinance (this is hypothetical, as a variety of factors will cause the outcome to fluctuate). Let’s assume:
Home value: $600,000
Current mortgage balance: $425,000
Current mortgage rate: 5.0%
Current mortgage term: 30-year fixed (started in 2017 when the home was bought for $550,000)
Household income: $140,000
Good credit, minimal other debt
Based on the above, here are the estimated costs to refinance:
Closing Costs: $3,500-4,000
Depending on the amount of escrow funds refunded to you from your existing loan, that refund will help offset some of the escrow pre-paids related to the new loan.
Redoing The Mortgage Application Process
Refinancing can be tedious. Be aware of changes in your income or credit score, which could impede obtaining the precise loan you seek.
Starting Back At Square One
Swapping a 30-year mortgage for another 30-year mortgage essentially turns back the clock on paying down the loan. Assuming that you do keep the same term length, you are starting all over again. While you decrease your interest rate and monthly amount, it increases the number of years making payments. That could disrupt your financial plan if you do not pay it off early.
Not Ideal If Planning To Move
Gauge your commitment to your home. Do you plan to sell in the next 10 years? If you sell your home soon after refinancing, you will pay all the costs to refinance without ever benefiting from the interest savings provided by the new loan.
Calculate your break-even point. For what it costs you to refinance, figure out how many months of interest savings it will take under the new loan before you offset those up-front costs. If you would like help calculating this, we can help.
Refinancing can be a wise financial decision. If done properly, it is valuable toward curbing your debt exposure. On the other hand, it can also be a costly mistake. Explore the benefits and consider the drawbacks. Use a reliable, trusted lender. Our friends at North Pacific Mortgage do an exceptional job of aligning your unique situation with the right mortgage. Contact me if you would like an introduction, or if you simply want advice on whether to refinance.
Hope you enjoyed reading!
Joshua J. Baird
Investment Adviser Representative